Welcome to the Auction
Few things in life are as majestic and pure as is the auction process at the heart of the financial markets. It’s anonymous, open to anyone and provides the best possible price at the time of a transaction. Understanding the auction is great preparation for trading, but seeing into the auction can actually improve your trading. How? To answer, we need to look at how prices originate within an auction.
Buyers and Sellers
Buyers and sellers exchange assets when they can agree upon a price. In the financial trading markets, the assets are securities (stocks, bonds) and contracts (futures, options, currencies). The auctions occur at organized exchanges that keep track of all orders and execute trades when both sides agree on a price. The auction constantly sets and resets that price, or more precisely, two prices:
The Bid: The amount a buyer is willing to pay to purchase. Buyers prefer to pay the lowest amount possible to complete a transaction.
The Offer: The proceeds a seller demands on a sale. Sellers prefer to receive the highest amount possible to complete a transaction.
The natural desires of buyers and sellers guarantee that offering prices are normally higher than bid prices. During market hours, every second sees hundreds or thousands of new bids and offers pour into the site of the auction — once trading pits but now mostly computers. At any given time, there are two critical prices at the auction: the best (highest) bid and the best (lowest) offer. The difference between the best bid and best offer is the spread. For a transaction to occur, the best bid must rise or the best offer must fall.
Price Specifications
Each exchange sets rules governing the smallest possible price fluctuation — the tick — and minimum trade size for a security or contract. On a stock exchange, the tick is a penny and the minimum trade is one share. On a futures exchange, different contracts have different ticks and sizes. For example, on the CME, the crude oil futures contract (the CL contract) has a unit size of 1,000 barrels and a tick of a penny per barrel, which translates into $10 change in value for each price tick. Conversely, the specifications for the E-mini S&P 500 futures contract (the ES contract) sets the contract size equal to $50 times the S&P index and the tick size is 0.25 index points, or $12.50 per contract.
In active markets, the spread between the best bid and best offer is usually one tick.
Active and Passive Orders
A trader places an order with an exchange by specifying a quantity of a specific security or contract to buy or sell. Buy and sell orders can be passive or active:
A market order is active. It instructs the exchange to buy or sell the order amount at the best possible price. A buyer placing a market order is willing to pay the best offer price currently available, whereas a sell market order transacts at the best bid price. These orders are called active because they execute immediately at whatever best bid or best offer is currently available. Thus, execution is guaranteed but price is not. Prices move because of market orders: buyers lifting their bids by paying the best offer or sellers selling into the best bid price.
A limit order is passive. A limit bid is an instruction to buy at a maximum price or lower. A limit offer sets a minimum price acceptable to the seller. These orders are passive because they are waiting for the auction price to rise or fall to the limit price. Execution is not guaranteed but the price (or better) is. Limit orders do not cause prices to move, but they can hold prices at a particular level until all limit orders at that price are filled.
Look for future posts where we will discuss how exchanges organize market and limit orders to provide orderly, efficient auctions. We’ll also explain how “seeing into the auction” allows you to assess the strength or weakness of prices by viewing the volumes of transactions arising from active and from passive orders.